The Private Equity Real Estate Podcast – Show 14
Summary
On today’s episode we have the cofounders of First National Realty Partners, Tony Grosso and Chris Palermo, discussing their step by step approach to due diligence once they have a commercial real estate property locked up.
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Announcer:
You are listening to the Private Equity Real Estate Podcast, brought to you by First National Realty Partners, where investors learn from private equity experts and insiders. We share our own real world experiences so you can know exactly what it takes to be highly successful at investing in passive commercial real estate opportunities.
Nick Cucci:
Hey, what’s going on, everyone? You are listening to the Private Equity Real Estate Podcast, brought to you by First National Realty Partners. This is the ultimate resource for passive real estate investors. I am your host, Nick Cucci. On today’s show, we have an amazing conversation with Chris Palermo and Tony Grosso, the co-founders of First National Realty Partners, and they are talking about arguably one of the most important steps of the commercial real estate buying process, which is conducting your thorough due diligence. We’ve talked about this before, but this conversation, it really digs in to what you need to do to make sure that you are being thorough prior to an acquisition of a commercial real estate property. We hope you get a lot out of it. Enjoy. Here’s a great conversation about conducting a proper due diligence.
Tony Grosso:
The main issue with acquiring commercial real estate is that, when you’re making offers, a lot of times you’re using incomplete or impartial information, you don’t have the whole story. You’re being supplied, a lot of times, information from a seller or a broker or an intermediary who represents a seller, and there’s really no way to verify 100% of that information without conducting thorough due diligence. There’s your conflict right there. It’s how do you make a bid? You have a set of numbers and then ultimately you find out something’s changed. That’s what the dilemma is, and that’s what makes conducting thorough due diligence and doing it the right way so important, because there’s so many little things inside of this period that can destroy a deal and could ruin you years down the line, so you have to conduct thorough due diligence and you have to have that idea that you’re going to be thorough and you’re going to get the correct information, which always isn’t the information that you’re bidding on when you first start throwing bids out.
Chris Palermo:
Yeah. And just to add on that point, the reason why is very simple. The broker who’s creating the OM represents the seller in the deal, so in order to have the property become more marketable, a lot of times these brokers will leave leases out, fudge numbers a little bit, and it’s our job as the buyer to make sure that we’re buying the income stream that we originally signed up for, and a lot of times more than not, that’s not the case. There’s always that conflict, which is what Tony was talking about.
Tony Grosso:
Which needs to be rectified.
Chris Palermo:
Exactly.
Tony Grosso:
Absolutely has to be rectified, because if you’re somebody who’s making a bid and the information is not complete, it’s inaccurate, something was misrepresented, somebody has to pay for that. You can try to do a lot of the lion’s share of the due diligence before you go to contract, but ultimately, in our deal cycle, typically we might get 90% of the story, and then we get the other 10%. The closer you can get to 100% before making your offer the better, but in the commercial real estate process, as a lot of people know, that always isn’t the case.
Chris Palermo:
You have to be on guard because a lot of times a lot of these brokers, they’re very eager to sell these deals, and certain times what is represented is not reality. The way you get there is by conducting your due diligence.
Tony Grosso:
Yeah. I don’t want to beat a dead horse here, but understand something. A lot of times you’re making a bid based off a commission salesman making his commission. The way he feeds his family is by getting a deal done, so a lot of these guys, they put a bunch of BS numbers in, they omit material information, and you’re left with an incomplete picture. You’re leaving up your purchase and acquisition based onto what some commission salesman is putting into a document. You have to keep that in mind at all times.
Nick Cucci:
Basically, when you guys even put in your first offer, you’re kind of doing it with a grain of salt, right? With the understanding that this offer, it’s based on this information, but the information may not be accurate, or we may find new information. Am I hearing that right?
Chris Palermo:
Yeah. Well, you have to start somewhere. You have to take what they provide as it being accurate, and based on what you find, you always work backwards, so of course.
Tony Grosso:
Yeah. What Chris and I like to do is we like to pretend, and we know it’s not the case, but we like to pretend that we’re getting the gospel. When they send us the NOI, if it’s say two million dollars, we expect them to uphold that NOI being two million dollars. And guess what? If it’s less, somebody’s got to pay. It’s really that simple. If somebody tells us that the roofs are in phenomenal condition, and then we send our engineer out there, we do a physical property condition assessment report, and we find out that they got two years left, we’re not schnucks here. You have to make sure that you get all of this information out in your due diligence process, because if a story is being painted different than the actual scenario, somebody’s got to pay. We work off that first original number and then we re-engineer backwards.
Nick Cucci:
Yeah, I know. It makes a lot of sense. Speaking of the due diligence process, Chris, I’ll ask you and I’ll let you dive into it. When do you start your due diligence process? What does that look like? When does that actually begin for you guys once you’ve identified your property?
Chris Palermo:
The due diligence process starts even before we have a deal under contract, but if you’re saying the former due diligence will be as soon as we make a down payment on the property, we put up the upfront money, and then usually within a certain period of time, typically 72 hours, all of the actual due diligence in which we start to underwrite the deal has to be released to us pursuant to the contract that we signed.
Tony Grosso:
Yeah. What Chris is… When he says down payment, he means your earnest money to ultimately bring consideration to the contract. There’s a couple ways to do it. Sometimes what we’ll do is you can sign an access agreement and get all the due diligence information prior to even signing a contract. Sometimes it’s upon both parties, seller and buyer, executing a contract. There’s different ways to skin the cat. Typically for us though, the due diligence clock doesn’t start until we have all of the material information so that we can start going through it.
Nick Cucci:
Okay. Chris, you kind of touched on it a little bit, and then, Tony, you also mentioned it. Are you guys doing your due diligence, maybe not formally, but somewhat informally even before putting in an offer? Or are you looking at an area of a property with demos?
Chris Palermo:
You have to. You have to, because even before you can put an offer on a property you have to make sure that that property is viable. You have to make sure that the area is well. What we look at as a company, being a private equity company, we don’t say to ourselves, “Hey, how much money can we make?” We say, “How, when, and what will happen for us to lose?” So, of course, due diligence has to start immediately when you start looking at a property, but the formal due diligence to make sure that the numbers or the income stream that you’re buying is accurate starts after we officially get a property under contract.
Tony Grosso:
Yeah. When you’re on the acquisition hunt, you have a business plan or an acquisition plan that you’re targeting certain types of assets, certain types of areas, product types, value add core, whatever you’re going after. I don’t really consider that due diligence. That’s more on the acquisition front. But what we’re talking about here is formal due diligence. At the end of the day, we try to start feeding out information before we even go to contract. We want to pull in as much information as possible, as fast as possible, and get the ball rolling.
Nick Cucci:
Yeah. Sure. Speaking of information then, what type of information do you look for from the brokers, from the owners? What specifically are you asking for to reassure yourself and everything else that the underwriting you did based on their numbers is accurate? What kind of information do you want from them?
Tony Grosso:
Again, even when a seller is providing information in a formal due diligence period, you still got to take everything that you see with a grain of salt. We’re getting all the information everybody knows. You want to do a physical condition report to make sure that the property is structurally sound, the roofs are good, the big operating systems, HVAC, pavement, the whole nine yards is in good working order.
Chris Palermo:
The leases.
Tony Grosso:
Then we step into the leases, which is really… We have a guy that only does his [inaudible 00:07:57] through leases. Leases really probably are the most cumbersome thing to handle in due diligence a lot of times because you’re dealing sometimes with multi hundred page documents, a million different clauses. Some of these tenants, they do short. You might see one lease might be six, seven pages, and then you look at a big national tenant who’s on a 30 year deal and they’re 300, 400 pages. The leases are a huge thing. Then you got to look at the financials. You have to audit those financials. You don’t just take it out of some guy’s accounting software and go, “Oh, okay. It looks good.” You then need to audit those to make sure that the net operating income matches up with the leases, the income, and then you have to verify all the expenses. It really is a cumbersome process.
Tony Grosso:
What I’ll say, though, is that we can typically get a lot of our due diligence done in a week, sometimes two weeks. What really holds up the process, guys, and I think you’ll agree, is the third party reports. You’re not going to get a formal phase one environmental study done in one week. You can rush it, but a lot of times that can take 21 days or more. Same thing with a physical. Our engineer might go out there, but we might want to get a formal report done. That could take a little bit longer. So the third party stuff can last a little bit longer. Based on the asset, how many tenants, et cetera, ultimately determines how fast you can get your stuff done.
Nick Cucci:
Yeah, that’s a good point. Chris, how long do you guys typically like to allot yourself to go through this process then? Because like Tony said, a lot of stuff you’re going to be doing, maybe it’s a two week span, you get all the information, you get what you need done, but then you’re waiting on third party people getting things back to you. How long do you want to, contractually speaking, have your due diligence drawn out for?
Chris Palermo:
Well, that’s on a deal by deal basis, but we’re typically looking at anywhere between 30 to 45 days, is usually what we have written in the contract. But again, as you go along, as issues happen, or if you see certain types of language in leases, or if you go through the physical condition property, important issues, typically what happens is we’ll write back through our attorney to the seller’s attorney and figure out a way to possibly extend due diligence. Typically, 30 or 45 days barring that there are no issues, but this is real estate. A lot of times there are issues, and sometimes we’re forced to extend due diligence because, at the end of the day, we don’t want our money to go hard unless we’re 100% sure that we’re buying exactly what we’re buying, and that goes not only from auditing all of the leases, but the physical as well, which can be very costly, at least in our space when you’re dealing with large institutional projects.
Tony Grosso:
I think that the answer to that question is we want as long as humanly possible. Real estate is all about control. When we talk about a due diligence period, because I don’t think we’ve even really said this, what we’re talking about is a period of time where we can cancel the contract for any reason, but still have the ability to purchase the property. It’s a very powerful position to be in, is to get control of a property and then be able to say, “You know what? Nah, we don’t like it, we’re out.” It’s a position that you want to put yourself into. But really we want to have as long as humanly possible. We’ve closed on deals inside of due diligence periods many times. We want to have as much time as possible because it gives us a little bit more hand, it gives us a little bit more control, and that’s really what real estate comes down to, is shifting control from somebody else’s favor into ours.
Nick Cucci:
Sure. No, it’s a good point, because when you’re going through the process, you want to be able to control the process. Right? You don’t want it to be in somebody else’s hands. To that point then, if you’re not getting the information you’re requesting, or maybe there’s more information outstanding, the broker or the owner is slow to get back to you, how do you nudge them along, or how do you make sure you get the information you’re asking for when it’s not being as readily supplied as you originally hoped?
Tony Grosso:
It’s a great question because, especially with mom and pop guys that you’re buying from time to time, you come across this, we specifically write in our contract, and this is the small nuance of being successful and not being successful. There’s a million little points, little legal points like this that I’m talking about that can ultimately tip the scales in your favor. When we write in our contracts, as far as the due diligence period is concerned, we don’t start due diligence until 100% of the information that we have requested is given to us. If these guys are late, we don’t start the due diligence period until they’ve given us that item. It’s really that simple. Everybody acknowledges, “Okay, here’s the start of due diligence period.” If they don’t give it to us, we can’t come off half up. There’s millions and millions of dollars on the line here, and if we don’t have all the information and the time that we need, they can go Mickey Mouse on some other buyer. You got to haggle everything you need to make the decision and move forward.
Chris Palermo:
Yeah. Look, this is the big leagues. If we don’t get any of the information, we’re not going to continue to start the clock. We have to be able to have all the information in front of us in order for us to be able to conduct due diligence. When you’re playing in our field, that’s a given.
Tony Grosso:
A lot of times there’s a lender involved, so they are going to have their own unique set of needs as well. You got to be able to take all that into account. Typically, the lenders are slower than we are. Like I said, we can get our crew on it pretty quickly and get the lion’s share of the stuff done in a few days sometimes, but ultimately, when there’s a lender involved, you need a little bit more time. A lot of these deals are done without financing contingencies, so in that 30 to 45 days, if any weenies are being hidden, is what one guy used on a deal, we got to make sure that we can pull them out for our lender so to speak.
Nick Cucci:
Now, with all the real estate you’ve looked at, I know you guys have looked at hundreds of deals, you’ve gone through the process countless times, can you give me an example of a time you’re going through due diligence, something doesn’t add up, the information’s not as accurate. How do you handle that situation? What is it that you do when you got a piece of information that’s either misrepresented or it’s just outright false from what you initially thought?
Chris Palermo:
Well, again, as I said before earlier in this, you’re buying an income stream, so if there’s anything that we uncover in due diligence, whether it’s physical, whether it’s lease, whether there was a misrepresentation on the OM, we’re getting an income stream, a percentage on our investment, and we want to make sure at all costs we continue to make that percentage that we thought we were going to make before we even put an offer on the deal.
Chris Palermo:
If there were numbers that were misrepresented, we’re going to re-trade or get a reduction in price or a credit at closing, whatever you want to call it, that will make sure that we’re signing up for what we originally signed up for. If we have a roof that costs a million dollars, well, they’re going to have to give us a reduction in price for a million dollars, because if we have to come up with an additional million dollars, well, we’re not going to make the same percentage return on the income stream that we initially proposed. That’s why that’s very important. If there was a lease that had a kick out clause, we’ve had that with a couple of big movie theaters, on some of the big centers that we’ve done, we have to account for that income, because again, we’re expected to make a specific amount of money for a specific period of time. So we will always re-trade. Tony, you want to add something?
Tony Grosso:
No, I think an income stream we’re buying, but it’s also a situation to take it to a higher level. You’re buying a situation. If somebody can kick out of a lease, you might still have that same income stream, but it’s not as strong as if they had the term that you originally signed up for. You’re buying into a situation, a situation is being presented to you, and if that situation changes, somebody has got to rectify that, or you ultimately have to be able to live with the situation changing and still be able to get in at that price. Now, I think that there’s certain spirit of the deal issues that we’re not even talking about. Stuff does happen inside of due diligence and stuff always needs to be rectified, but there’s a difference in my opinion between a material omission, which happens all the time, and something changes while you’re in due diligence.
Nick Cucci:
Can you give an example of what something like that would mean?
Tony Grosso:
Yeah, we’re talking about a kick out clause. We were doing a deal and it was completely misrepresented in an offering memorandum, which Chris was saying, OM, it’s where they put all the information on a deal. There was a tenant that had 10 years of term, is the way it was being pitched to us. We uncovered, there was only seven years of term. That doesn’t sound like a lot, but three years out of a bigger… That’s a huge deal. Some guys, there’s no environmental issues, and then we get in and there’s an environmental issue. You got to step into these deals with an open mind. This is business, this is the big leagues, guys are trying to screw and hose, thieve and rob left and right, so you got to have your head screwed on straight and you have to have a team of people that knows what they’re doing, because if you’re not conducting and doing this the right way, you could step into a situation and not be able to cover debt service they wanted. I’ve seen guys get in trouble before. You have to really dig into this stuff. There’s a difference between a picture of what’s going on in an offering memorandum and an actual situation. The goal with this due diligence period is to uncover the actual situation and still be able to have value in your deal.
Chris Palermo:
Yeah, because you to know what’s the state of mind of the tenant. What Tony’s trying to say, if you have a tenant that’s paying you rent every single month, but they have a kick out clause and they’re not doing as well as we thought they were and we were buying the property at a competitive price, and we found out that one of the anchors is not performing as well as we thought, well, even if they’re paying, we might have to re-trade because the state of the deal is not the same state of the deal that we thought we were buying, if that makes sense.
Tony Grosso:
We’ve had guys materially misrepresent net operating income. I’ve seen net operating income overstated by 50, 60% from time to time. In those situations, a lot of times you got to walk away because the seller had a certain price in mind or the broker lied, there was a tenant that was supposed to be going in that was in the offering memorandum, they weren’t going in. A lot of times there’s situations that can be rectified inside the due diligence period, what we’re talking about re-trading the deal. Sometimes though, there’s just a moat, you’re just too far apart. They’re saying the NOI is three million, you get in there, it’s actually 2.1 million. A lot of times, you have to take a major hit, the seller would have to take a major haircut, and you’re just too far apart, so you got to pull the plug, but you got to know what the actual situation is so you can make that calculated decision.
Chris Palermo:
I just want to add one other thing, and I don’t want to get off topic, but the craziest thing is this. The seller will know that he’s selling you something that is not actually what is, but they have a specific price in their mind, they sell themselves their own lie of why they’re selling the building at X, and then when we uncover what the truth is and we want to re-trade for why, mentally and socially they’re stuck on X.
Tony Grosso:
Absolutely.
Chris Palermo:
It’s the craziest thing.
Tony Grosso:
It’s funny, it’s because a lot of times it’s saying, I heard, buyers are buying on cap rate, and sellers are selling on an actual number or a price. Trying to rectify those issues when they don’t match up sometimes can be very difficult.
Chris Palermo:
Yeah. It’s like a play with human psychology, these deals.
Tony Grosso:
Speaking of psychology, I don’t want to go on a tangent here, a lot of times you need to uncover the psychology of the seller when you’re buying a property to know what you can get away with. Some guys will drop the drawers, some guys won’t move an inch. Trying to figure out the psychology of the seller and doing it in a covert way can add value a lot of times.
Nick Cucci:
Knowing the real story as to why they’re selling or what’s motivating them to unload the property, basically.
Tony Grosso:
Absolutely right. Anything that you can do to get information in your favor of the psychology of the guy selling it and knowing what state he’s in financial, mentally, physical, whatever, the partnership status of a guy, a bunch of guys own it together, a REIT is disposing because they’re shifting model, whatever it may be, the closer you can get to the accurate picture of what’s going on, not only psychology, but the actual numbers and what’s going on with the property, the more ammo you have in your negotiation. Clearer head, you can negotiate with.
Chris Palermo:
Because you have to articulate why they need to sell or why they need to sell to you.
Nick Cucci:
Let me ask you then, because a lot of times, especially when you’re dealing with these large institutions or REITs or whoever, big ownership groups, a lot of times you never have direct access to the owner himself or herself, you’re dealing with the broker or whoever their representative is. So in the situation where maybe the only communication you’re having is through the broker, do you find it more difficult to uncover the true reason behind why they’re selling? Is that a hurdle that you have to learn to get over as you become more experienced doing deals?
Tony Grosso:
You hear stories. Sometimes you hear a guy’s selling for this, but he’s actually selling for that. Sometimes you actually know what the actual picture is. Each deal is a little bit different. There’s been deals when we heard one story, but it turned out it was something else, and we still move forward with the transaction. Understanding the guy’s psychology is not always crucial to getting a good deal. I was just making the case that the more info you have, the better chance you have of going back to that guy and seeing. If a guy’s not motivated to sell and you’re buying a deal for 30 million dollars and you ask for 10 million dollars off the purchase price, he’s going to tell you to go pound sand, because he doesn’t even need to sell it. Sometimes guys that don’t need to sell, they won’t give you a dollar off the purchase price. Whereas, if the guy is incredibly motivated, he’s getting a divorce, he’s going to go bankrupt if he doesn’t sell the property, but he needs the cash injection, that guy is more motivated to make a deal than the aforementioned guy. Just try to get as much information as you can about the situation.
Chris Palermo:
To answer your question directly, whether it was an institution or an individual, or getting in contact with the person who… Really, it’s all irrelevant. I’ve seen it work buying from a REIT being easier than buying with a guy that has owned the property for 50 years. What I can say is this, though. If we’re talking about re-trading, we’re talking about a reduction in price, you want to make sure that you time this reduction at the height of the emotional commitment of the seller. In other words, if you see issues, you want to make sure that you jot it down and you keep it close to the vest. The only suggestion I would make is make sure that you do the re-trade at the end of the due diligence period. Why? Because the seller is more apt psychologically and motivated to sell because more time has elapsed.
Tony Grosso:
They’re more pregnant in the deal, is the word that we like to use. You know what? It’s kind of a double-edged sword though, because as long as you’re comfortable walking away, I think what Chris just… And that’s what we always are. We’ll walk away from a deal, we don’t care. No matter how deep into a deal, you can’t go out and spend millions and millions of dollars if the situation is not in your favor, if you’re not getting a fair deal, if you don’t know that you’re going to be successful with the deal, you can’t do it. That’s why sometimes, to the end of the due diligence period, everybody, including us, including the seller, is more pregnant in the deal and they’re willing to bend a little bit, so to speak. If you come out in the first week, “There’s no way we can make a deal,” but you have to be willing to walk away if you can not get your price. You have to keep that in mind.
Nick Cucci:
Yeah. I think knowing and remembering that you can walk away and not get married to a deal is super important.
Chris Palermo:
That’s the difference between success and failure right there. Many people will say the issue. They sell themselves on why they need to own the property, and they say, “You know what? I’m good enough to change what was wrong and I’ll make it better one day.” And it goes back to you make your money on the buy. You have to make sure that you buy right, and if things happen, you’re able to be able to overcome it. To do that, circling it all back around. You have to make sure that you’re buying the income stream and the state of the property that you originally signed up for.
Nick Cucci:
Yeah. That’s great advice by both you guys. Just to remind everybody, don’t forget you can check out both Anthony and Chris’s bios on our website FNRPUSA.com, as well as all the rest of the information on our firm.
Nick Cucci:
Guys, as we wrap this up, I wanted to ask you really just one more thing, and that’s what advice would you have for someone who maybe isn’t as experienced as a group like ours, who’s going through the due diligence period? What are some things, maybe one bit of advice you’d give them to look out for or conduct themselves? Give me something that someone listening now can hang on to next time they’re in their due diligence period.
Tony Grosso:
What I’ll say is this. Do not get involved in a complex, high stakes business or commercial transaction if you do not have the ability to properly underwrite a situation. Everybody wants to be a real estate investor, go out and do deals, and it’s a lot of fun and stuff, but so much can go wrong if you’re not thorough. We have an entire staff of people. We might only be working on, many times we’re working on multiple deals at a time, but there’s times when we’re only working on one deal and we have our entire staff combing through leases. Physical men are down there, our accountants are running through the numbers and doing their audit. There’s just so much that goes into it, and especially these leases. You’re talking about legal jargon that’ll make your head spin. If you don’t underwrite the situation correctly, there’s a high probability that you can lose.
Tony Grosso:
If you don’t have the staff, if you don’t have the resources, if you don’t have the time, the thoroughness, and ability to conduct your due diligence on a property correctly, I wouldn’t even do the deal. I wouldn’t even get into the business, honestly. Look, Chris and I, we’ve made mistakes in our careers. There’s deals where we learned… We learn on every single deal how to make it better, but there’s just certain things, if you can’t go through properly and get the accurate picture of what’s going on, you have no business bidding. Go invest with somebody else or don’t even get in. It’s that simple. That goes for all investments, but that’s just my two cents.
Nick Cucci:
Chris, what about for you?
Chris Palermo:
I would say this. The real estate business, commercial real estate is a very complex business, and you have to make sure that you protect yourself, you have to make sure that you conduct all of your due diligence and put all the work upfront, and don’t get emotional. Be prepared to walk away. It’s a lot better to lose, let’s say, 5 or 10 grand than getting your property repossessed because you emotionally committed. And then the last thing is, is don’t ever be afraid to articulate your points on why you think what you’re buying is not the case and ask for a re-trade. Remember, these people are selling the property for a reason. It’s your job as the buyer to find what that reason is, exploit that reason, and more importantly, when you see deficiencies, have the ability to articulate why you as the buyer are the right buyer and that any other buyer that comes in to buy this property is going to have the same issues that you’re going to have. And if you articulate that point, usually the people that are selling will agree, buying, that they want to sell, and you’ll get probably an even better deal than you set out for. Tony and I, we do this unconsciously on every single deal. We wouldn’t see it any other way. And I want you guys to be the same way.
Nick Cucci:
That was Chris and Tony talking about how they approach a proper due diligence once they have a commercial property under contract. I can’t thank you guys enough, again, for the wisdom and your experience. I’m sure everyone listening was able to take something away from that. Thank you all, by the way, for listening to the Private Equity Real Estate Podcast. If you like what you’re hearing, leave us a review, subscribe, share the show, get it out there. If there’s anything else you want to hear us discuss, please reach out, let us know. This show is brought to you by First National Realty Partners, one of the top private equity commercial real estate firms in the country. If you’re interested in learning more about FNRP or would like to get access to our private offerings, please click the link in the show notes or visit FNRPUSA.com. Remember, this show is for educational purposes only and should not be considered a solicitation to purchase securities or be construed as tax, legal, investment, or accounting advice. Thanks again for listening, everyone. We will see you next week.
